Income Strategy 2014: Thinking In And Out Of The Box

As a bountiful year on Wall Street comes to an end, most investors have plenty of reason to revel. With the mystery of the Fed's initial bond buying taper now history, a layer of market uncertainty finally has been peeled away. Yet, as interest rates continue to hover near historical lows and yields on dividend equity drop in tandem with their rising prices and valuations, income investors may find it just a bit harder to find attractive income opportunities as a new year dawns.

Indeed, with earnings multiples of some of the market's bluest of blue chip dividend names including Procter & Gamble (NYSE:PG), Coke (NYSE:KO), Colgate (NYSE:CL), and even General Electric (NYSE:GE) becoming frothy, caution is advised on upping exposure to these types of companies. Though business and economic fundamentals for blue chips appear to be stable, albeit not particularly robust, I would argue that the momentum behind the current pricing pendulum should soon be losing steam.

Blue-chip Valuation Vitals

Stock

YTD '13 Price Change

Current P/E* ('13 est)

'14 EPS Growth Est.*

Yield

PG

19.8%

19.2

8.6%

2.94%

KO

7.4%

19.1

6.7%

2.80%

CL

22.4%

22.8

9.5%

2.10%

GE

26.3%

16.6

5.1%

3.22%

* Via analyst estimates on Yahoo Finance

Thus, to find the best bang for one's nominal income investing buck in the new year, equity-income investors need to closely scrutinize valuation and earnings/dividend growth rates. I also think that some creative positioning may be advised as well as some open-minded thinking towards areas of the market one may not normally be predisposed to considering.

Thinking Strategy

Because there are a multitude of strategies and a variety of ways and means associated with income investing, I don't consider it purposeful to argue for one avenue over another. Suffice it to say that I think investors are best served by considering all available alternatives and picking overriding strategies and securities that best get one from Point A to B in their investing endeavors.

Having said that, my personal preference is for employment of a "go anywhere" hybrid strategic model, with incorporation of a variety of thought into a portfolio including total return and dividend growth, as well as passive and more active positioning. In addition to equities, I advocate utilizing bonds, preferreds, options, and varying levels of cash to provide superior risk-adjusted returns and cash flow.

Thinking Equity-Income

While I don't think investors should necessarily be in a rush to jettison them from portfolios, established blue chips, like the ones mentioned above, selling at around 20X earnings and growing less than 10%, pose an elevated level of capital risk in the year ahead in my view. Thus, it may be prudent to seek out companies selling at lower output (earnings/cash flow) valuations with similar growth characteristics and yields.

With valuation being the watchword, I think the energy patch is a great place to look right now. Names like Chevron (NYSE:CVX), which I recently added to my portfolio, oil rig/drilling play Ensco (NYSE:ESV), which raised its dividend by 75% and now yields well over 5%, as well as BP look like good buys for income seekers right now.

Some other value names with elevated yields and decent total return potential where I wouldn't be afraid to allocate capital to include tobacco/alcohol giant Altria (NYSE:MO), Canadian finance powerhouse Bank of Montreal (NYSE:BMO), and shipping container lease outfit, Textainer Group (NYSE:TGH).

From a pure dividend growth perspective, I continue to like prospects for cash return and current operating value from Apple (NASDAQ:AAPL) and Cisco (NASDAQ:CSCO), despite likely continued erratic EPS growth from both going forward. I'm also somewhat uncomfortably sticking with a Target (NYSE:TGT) recommendation. This has been a difficult year for the retail giant, with lackluster results from its foray into Canada and an in-store credit card compromise, which looks like it will eat into holiday sales results. Still, the company has promised investors 20% dividend growth for the next several years.

Stock

YTD '13 Price Change

Current P/E (13 est)

'14 EPS est. growth

Yield

CVX

11.3%

10.73

4%

3.26%

ESV

(9.4%)

8.81

18%

5.46%

BP

10.4%

10.41

15%

4.87%

MO

20.0%

16.13

7.9%

4.98%

BMO

5.5%

10.44

6.2%

4.37%

TGH

23.7%

12.71

13.5%

4.75%

AAPL

(.1%)

12.6

9.4%

2.22%

CSCO

0.5%

10.67

5%

3.22%

TGT

6.7%

17.3

28%

2.75%

Thinking REITs

While the boom and bust cycle that real estate investment trusts experienced in 2013 was perhaps one of the bigger sector stories of the year, I think prices have dropped to a level where investors should feel more comfortable once again about investing. Though the year ahead may not be one of robust total return, most REIT dividends seem by and large healthy and durable. Still, investors should also consider the ramifications of a persistent rising rate environment on the group.

Keeping with the value theme, I would probably advise shying away from the larger cap, household names like a Simon Property (NYSE:SPG), AvalonBay (NYSE:AVB), or Realty Income (NYSE:O) and look at REITs trading with lower FFO and AFFO multiples. One can find higher yields and may see better total return by looking at some of the smaller trees in the REIT forest. I continue to like apartment landlord Home Properties (NYSE:HME) and hotel owner LaSalle (NYSE:LHO).

One name that I owned a year ago, sold during this year's run-up, but have decided to add back to my portfolio is Lexington Properties (NYSE:LXP). The company leases a mix of property mostly on a triple net basis to a diversified group of tenants. The company continues to deleverage its balance sheet and sells at a very low FFO multiple, with an attractive 6.5% yield.

Another name I'm watching closely, but have yet to pull the trigger on, is HCP, a diversified owner of healthcare facilities. The company sees rent checks from senior housing, skilled nursing facilities, life science and medical office buildings, and to a lesser extent, hospitals. Given a 35% drop in stock price from highs earlier this year, it is starting to look attractive. While expectations are fairly low next year with new management at the helm, the valuation is low as well. With a nearly 6% yield, I think this could be a diamond in the rough, presenting a decent total return play next year.

One REIT that I've pounded the table on through the course of this year was NorthStar Realty Finance (NYSE:NRF). After announcing that it would spin off its asset management business, the stock has rocketed higher by better than 30% near-term. While I still think there is embedded value in the company, I don't think I would aggressively pursue it here, and would probably look to trim an overweight position.

REIT

FFO or CAD Valuation ('13 est.)

'14 Growth est.

Yield

SPG

17.6

8%

3.1%

O

15.6

5.8%

5.8%

HME

12.15

3.7%

5.3%

LHO

13.8

12.6%

3.5%

LXP

9.8

8%

6.5%

HCP

12.1

2.3%

5.8%

NRF

11.8

14.4%

6.4%

Thinking Bonds

With the specter of higher interest rates as a looming backdrop, fixed income continues to be perceived in a negative light, given the risks associated with long maturity bonds in a rising rate environment. Yet, I still think there is value here from a variety of angles. Investment grade bonds can serve as a buffer to a portfolio dominated by equities and provide an elevated source of yield as compared to cash investments.

And with high-yield default rates still hovering in the 2-3% range, junk debt certainly does not appear fraught with risk. Still, investors looking at the bond market need to be realistic and conscious of the variables surrounding credit quality, duration sensitivity, and call risk.

Some "out of the box" thinking with regard to bonds would be to consider CEF exposure, especially for fixed assets with higher credit risk and potentially municipal exposure. Some closed-end bond funds are trading at extraordinary discounts to net asset value, creating the opportunity for investors to purchase pooled fixed income assets for between 85 and 95 cents on the dollar, with associated yields nearing ten percent.

Due to the perceived risks in bonds, CEFs have done an about face over the past 18 months, in some cases moving from sharp premiums and limited yields, to discounts and robust yields. While many CEFs have additional moving parts including leverage and managed distribution policies, the value here is worth a look in my opinion. Western Asset HY Opportunities (NYSE:HYI) is one of my favorites as well as Alliance Bernstein's Global HY (NYSE:AWF).

Thinking High-Yield Plays

Business development companies and mREITs continue to be popular alternative sources of double digit income for investors. The BDC, which is much akin to a high-yield bond fund, takes primarily debt, and usually to a lesser extent equity positions, in small to middle-market private enterprises and passes its cash flows on to investors. Mortgage REITs invest in both residential and commercial real estate typically on a variably leveraged basis, providing a return to investors based on the spread between respective income and borrowing costs.

Both types of securities are evaluated partially based upon book value. Just like the closed-end fund, when market prices are above last stated book value, the stocks are said to be trading at a premium, and when the opposite is true, they are said to be trading at a discount.

While not ironclad rules, BDCs have tended to trade "around" book value, while mREITs have tended to trade wildly, and now sit in general at high discounts to book value. I tend to think that BDCs are a reasonable source of elevated income, but find mREITs far too difficult to judge on a quarter to quarter, mark to market basis. Thus I deem them too high of a gamble for most investors seeking a conservative income stream.

Prospect Capital (NASDAQ:PSEC) is my only exposure to the BDC space, while I have no current exposure to mREITs. I have to say despite my general negativity towards mREITs, the extent of some of the discount is piquing my interest. If I were to make a recommendation, I'd probably push one towards REM, an iShares diversified ETF product. For individual exposure, I would recommend Annaly (NYSE:NLY) or MFA Financial (NYSE:MFA). Still, despite the discounts, I would not go hog wild here due to the inherent volatility of both capital and income.

Thinking Options

Options can provide both an income boost to existing positions or can offer a way to generate income while waiting to own a position. There are two ways income investors can juice an income portfolio with fairly simple options strategies.

Covered Call Writing: Gain premium income by writing (selling) call options against a position you already own, but wouldn't mind selling at a specific price.

Cash Secured Put Selling: Gain premium income by selling puts on equities you don't own, but wouldn't mind owning at a specific price.

Though options strategies can be an effective way of enhancing income, they are not risk free. They tend to be most effective in benign markets, and ineffective in runaway markets. One should have thorough understanding of both call and put concepts, as well as respective risks and rewards, before making simple or more complex option strategies part of an income or overall investment strategy.

Thinking Asset Allocation

So how much of your income portfolio should you allocate to each of the spaces we've discussed? My view is that the "safest" income portfolio incorporates and diversifies amongst all of the above mentioned strategies, sectors, and income generating methods. Moreover, the safest of income portfolios will hold a sufficient number of positions to mitigate concentration risk. However, risk tolerance and the "sleep well at night" threshold will vary from person to person, making the allocation issue something one can only independently come to terms with.

In the past, I've written articles (I,II,III) that have taken up the allocation question and offered ways for income investors to view the pros/cons and carefully evaluate the selection of higher yielding versus lower yielding securities. I would also suggest a thought provoking article from Tim McAleenan that discussed the merits of owning a portfolio made up only of blue-chip equity.

Final Thinking

Continued low interest rates and a robust 2013 equity market will provide income investors continued challenges heading into next year. While the Fed has finally moved to end its bond buying stimulus, providing for some near-term clarity, macroeconomic factors may continue to play havoc with interest rate sensitive income securities. The average income investor should properly diversify themselves, employing appropriate tactics and/or utilizing a variety of security types to secure and potentially enhance an income stream or maximize total return in what will likely be a less jubilant 2014 market.

Disclosure: I am long AAPL, AWF, BMO, CL, CSCO, CVX, ESV, GE, HME, LHO, LXP, MO, NRF, PSEC, TGH, TGT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.

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